Revision Notes

What is Cost?

All payments made by a firm in the production of a good or service are called the cost of production. These costs can be classified in different ways.

Types of costs

Fixed Cost and Variable cost

Fixed costs are expenses that do not change in proportion to the activity of a business, within the relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective of sales. Variable costs by contrast change in relation to the activity of a business such as sales or production volume. In the example of the retailer, variable costs may primarily be composed of inventory (goods purchased for sale), and the cost of goods is therefore almost entirely variable.

In manufacturing, direct material costs are an example of a variable cost. An example of variable costs is the prices of the supplies needed to produce a product.

A company will pay for line rental and maintenance fees each period regardless of how much power gets used. And some electrical equipment (air conditioning or lighting) may be kept running even in periods of low activity. These expenses can be regarded as fixed. But beyond this, the company will use electricity to run plant and machinery as required. The busier the company, the more the plant will be run, and so the more electricity gets used. This extra spending can therefore be regarded as variable.

Along with variable costs, fixed costs make up one of the two components of total cost. In the most simple production function, total cost is equal to fixed costs plus variable costs.

It is important to understand that fixed costs are "fixed" only within a certain range of activity or over a certain period of time. If enough time passes, all costs become variable.

In retail the cost of goods is almost entirely a variable cost; this is not true of manufacturing where many fixed costs, such as depreciation, are included in the cost of goods.

Although taxation usually varies with profit, which in turn varies with sales volume, it is not normally considered a variable cost.

Variable costs are expenses that change in proportion to the activity of a business. Along with fixed costs, variable costs make up the two components of total cost. Direct Costs, however, are costs that can be associated with a particular cost object. Not all variable costs are direct costs, however; for example, variable manufacturing overhead costs are variable costs that are not a direct costs, but indirect costs. For example, a manufacturing firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw materials is used and spending therefore rises.

Average cost per unit

Average cost is equal to total cost divided by the number of goods produced.

Total cost/output

It is also equal to the sum of average variable costs (total variable costs divided by Output)

Marginal cost

Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. In general terms, marginal cost at each level of production includes any additional costs required to produce the next unit. So, the marginal costs involved in making one more wooden table are the additional materials and labour cost incurred.